Tuesday, January 21, 2014

We Were Dividends, Before Dividends Were Cool

For a while it seemed that every investing article ended with the same conclusion - you should be buying dividend stocks. They are all quoting studies citing the performance edge that dividends have enjoyed over the long-term and the value of a semi-fixed return generated from periodic dividend payments. However, you should beware of some of the information provided. Beyond the simple concepts, some of the writers are making really bad recommendations and cross-breeding dividend investing with their preferred form of investing.

Dividend growth investing is not about exit points, momentum swings, relative strength, sector rotation; instead it is about studying fundamentals, selecting superior stocks and building a portfolio with a long-term horizon. When we buy a dividend stock, we hope to hold it forever. What makes a good dividend stock? Here are some of the things I look for:

Good Business Model

Sell things that people want or need, and do it in such a way that it is difficult or impossible for others to duplicate. There is a reason that pharmaceutical companies, such as AbbVie Inc. (ABBV), are so profitable. With effective drugs under patent that sustain or enhance people's life these companies have a deep moat. Consumer goods companies like Procter & Gamble Co. (PG) and Colgate-Palmolive (CL) manufacture products such as soap, detergent, toothpaste and toilet paper that we just can't do without. Sure, there may be generic substitutes, but over the years many of these products have endeared themselves to consumers who are willing to pay a few cents more for the name brand.

Strong Free Cash Flow

Dividends are paid with cash remaining after paying the operating expenses and replacement capital (free cash flow). If a company has trouble meeting these basic needs, then its dividend is perilously at risk. Companies with a low free cash flow payout (FCF) payout are well-positioned to sustain their dividend. Such companies include: AFLAC Incorporated (AFL) at 4.89% FCF Payout, Phillips 66 (PSX) at 18.64%, Lowe's Companies, Inc. (LOW) at 22.67% and International Business Machines Corp. (IBM) at 28.02%.

Acceptable Debt Level

Generating a strong free cash flow is not enough - cash has to be available to be paid as dividends. As a result of the economic downturn, many companies are feeling pressure to reduce debt to stay within their covenants and try to maintain their debt rating. If a company's excess cash is being used to service debt, there may not be any left over to increase dividends. Companies with a low debt to total capital include: Automatic Data Processing Inc. (ADP) at 0.24% Debt to Total Capital, Nike, Inc. (NKE) at 10.86%, Exxon Mobil Corporation (XOM) at 11.18% and Monsanto Co. (MON) at 15.08%.

Good Balance between Dividend Yield and Growth

There is usually a reason why a stock's yield is above average. Often it is the market's way of saying it doesn't believe the company can maintain the dividend. Most people understand this risk. However, there is also risk to a stock that has a high dividend growth rate. To maintain a high dividend growth rate the company has to grow cash available for dividends at the same rate. This is often difficult to do.

Here are several companies with a good balance between dividend yield and dividend growth rate: The Coca-Cola Company (KO) 2.85% yield and 8.02% dividend growth rate, McDonald's Corporation (MCD) 3.29% yield and 8.71% growth, The Clorox Company (CLX) 3.16% yield and 8.78% growth, Johnson & Johnson (JNJ) 2.72% yield and 7.29% growth and Kimberly-Clark Co. (KMB) 3.07% yield and 7.07% growth.

For those of us that have invested in dividends for years (decades for some of us), we know dividend growth investing is not a passing fad to be "played" then move on the next hot investment strategy. Part of me will be glad when dividend investing falls out of favor and the masses moves on.

Full Disclosure: Long ABBV, PG, AFL, ADP, XOM, KO, MCD, JNJ, KMB in my Dividend Growth Stock Portfolio. See a list of all my dividend growth holdings here.

Related Articles
- Why We Are Dividend Growth Investors
- 6 Dividend Growth Stocks With Very Little Debt
- What Determines A Dividend Stock's Yield
- Warren Buffett's Secret To 50% Returns
- 9 High-Yield Energy Stocks Growing Their Dividends

(Photo Credit)

Tags: [ABBV] [PG] [CL] [AFL] [PSX] [LOW] [IBM] [ADP] [NKE] [XOM] [MON] [KO] [MCD] [CLX] [JNJ] [KMB]